Chapter 7: Modeling RWI and EOP Contracts to Mitigate M&A Valuation Risk

Often, strategically assertive mergers and acquisitions (M&As) fail to be consummated for valuation risk or for the inability of the buyer to mitigate such risk. Buying and selling businesses is complex. A witty deal structuring may help cover implied valuation risk embedded in the future free cash flows of the target firm. A buyer tends to undervalue a target due to a risk-induced outcome. When the buyer is apprehensive about the fair price of the target, he thinks of protection from valuation risk either by insuring a post-purchase performance guarantee given by the seller, known as representation and warranty insurance (RWI), or a deferred payoff called earn-out payment (EOP). In RWI, the buyer transfers a portion of the valuation risk to an insurance company, while in EOP, a part of the payment is withheld and subsequently paid depending upon the future financial performance level of the acquired business. There are circumstances when the degree of uncertainty about the target firm’s future cash flows is so high that it pushes both parties outside the likely agreement zone (LAZ). The study of RWI vis-à-vis EOP in M&A is randomly found in scholarly articles, and due to this reason, this chapter attempts to establish which tool is superior to the other for valuation correction.